Peter's Perspective
17th April 2014 by Peter Churchouse

The “Through Train” is a Happening

In December we wrote a short piece following the 3rd Plenum of the 18th Communist Party held in November. One of our core observations was that liberalization of China’s financial system was front and centre (alongside environmental issues).

Specifically, I was of the view that one part of this financial liberalization would involve a re-establishment of the “Through Train” concept that had been established briefly in 2007 and then abandoned. This move had proved electric for the Hong Kong stock market. Stock market volume went through the roof and the Hang Seng Index soared by close to 50% in the following ten weeks. See chart below.

Hang Seng Index - 2007. May 2007: Plans to widen QDII announced. Details of investor rules released. August 2007: Through Train proposal announced. Tianjin announced as experimental city for individual investors. November 2007: Plan unofficially suspended. Premier Wen remarks that more time is needed.

The Through Train has just been put back on the tracks.

It will likely have significant upside impact for the Hong Kong market, but probably not prove quite as explosive as the first time around.

Don’t Dismiss China Policy Missives as Just so Much Waffle – They are Not.

Although the 3rd Plenum was widely discussed beforehand, the event itself was portrayed by much of the media as a big yawn. But it is not. It never has been. It matters, to China and to the rest of the financial world. Its importance should not be underestimated and it is easy to get wrong. If the Chinese authorities move to execute even half of the policies laid down, and even achieve these only in part measure, China and the world will be a rather different place in ten years.

It will likely open up very substantial opportunities for investors and businesses both in China and offshore.

We should not ignore these opportunities.

Much media commentary on the official statements that emerged from this widely anticipated event reeked of disappointment. It was dismissive. Sometimes condescending.

It is wrong to be so inclined. These once-a-decade strategy sessions are supposed to simply point the direction and give some qualitative enunciation of an end result. Achieving that result is, and always has been, left to the bureaucrats and politicians to sort out. The difference between such policy statements in China and most countries in the west is that the Communist Party has the power to knock heads together to achieve the stated goal. Debates about the efficacies of democracies vs. autocracies aside, suffice to say that China over the last few years has demonstrated an unerring ability to achieve the goals it sets itself. It may not always be pretty, and people may get compromised along the way, but the end results so far have blown away most skeptics and cynics.

One area that we have discussed in recent AHA Reports is the 3rd Plenum’s focus on the environment and the impacts for companies in this space.

A second big, important theme of the 3rd Plenum has been the subject of financial sector reform. The main thrust of this centre on reforming the interest rate regime, the foreign exchange regime, capital controls, tax regime, municipal finances and much more.

Specifically we reckoned that an early part of this reform package would focus on re-establishment of the “Through Train” concept. Originally mooted in 2007, the “Hong Kong Stock Through Train” would have allowed individuals in China to buy stocks listed on the Hong Kong exchange. Prior to this, capital controls had made investment in any stocks outside of China impossible for domestic investors. If successful, the plan was to then expand the program to other markets.

Domestic appetite for stocks in China was huge at the time. The market was in cloud cuckoo land with valuations that make the current overheated US market look like a bargain basement. The through train was intended to take some liquidity out of the massively overheated local “A” share market, which was apparently being punted by every man and his dog at the time. The number of brokerage accounts in China, already high in 2006 at a little over 40 million (yes, 40 million) rose sharply to over 70 million in 2007.

I remember a newspaper article in mid-2007 reporting that China’s major stock brokerage houses had opened more than 300,000 new brokerage accounts in the previous ten days. Imagine the paperwork these five or six brokerages had to deal with, opening so many accounts in such a short space of time. Average daily turnover in China’s stock exchanges increased by about five times from 2006 to 2007.

But Hong Kong’s market was largely immune from all this heat. Major China companies whose shares traded in Hong Kong typically traded at 100% premium or more to those company’s shares in China.

However, the moment that the Through Train proposal was announced the Hong Kong stock market took off, rising about 60% in the following three months to a high that has not even been approached since that time.

This all happened without the “Through Train” ever being formally implemented and Chinese investors found ways to pile money into Hong Kong anyway.

When Premier Wen expressed some concerns about the impacts on stock markets, during his visit to Hong Kong at the height of the market frenzy, most of these gains in the Hong Kong market were given up in the next three months.

Today’s equity market environment in China is very different from that of 2007 when the first Through Train was announced. It is in the dumps to put it mildly. Slowing economic growth, credit problems and lack of trust in the market have kept China’s retail hordes on the sidelines. Real estate has become the investment of choice for many these days. The Through Train model announced last week is broader in scope than its earlier version. The proposal is to allow Chinese investors to invest in Hong Kong stocks but also to allow Hong Kong investors to invest in shares listed on the Shanghai stock exchange. But the scheme places a cap on the daily volume of trading allowed and also a limit on the total amounts of investment that can be made in each direction. Like most policy shifts in China, the move is an experiment to test the waters. If the policy meets with success, the caps will likely be raised, and the scheme extended to other assets classes such as bonds and commodities.

This represents another step in the liberalisation of the Chinese currency.

This version of the Through Train is unlikely to produce the same level of excitement that came with the original proposal in 2007. Appetite for stocks by Chinese investors is a far cry from those mad days of 2007. But nevertheless, even a more restrained Through Train is likely to have a positive impact on the Hong Kong stock market, even if it is not the wild surge that accompanied the first version.

The Hong Kong stock market is not expensive right now and this move, to be implemented in earnest in October, will likely produce some decent upside pressure. While not the 60% plus that accompanied the last Through Train effort, I would not be surprised to see some 15% – 20% upside to the Hang Seng Index over the coming months if this new proposal is confirmed and executed.

How to play this?

The simplest option is to buy the Tracker Fund of Hong Kong (2800 HK) which is an ETF that replicates the Hang Seng Index (HSI). It’s a cheap ETF with an expense ratio of only 0.15%. And the HSI looks like good value right now as well, trading at around 10.5 times earnings. This is about 1 standard deviation below the 10 year average.

Looking at the composition of the index below, you’ll see it’s pretty heavily weighted towards the financial sector, with nearly a third towards the banking sector. Around half of that is HSBC, with the rest being the major Chinese banks.

For those nervous about exposure to the Chinese banking sector, we recommend either Cheung Kong Holdings Ltd (1 HK, HK$136.50) or Hutchison Whampoa Ltd (13 HK, $107.40).

We recommended Cheung Kong back in August of 2013 (see our AHA Report “Asia’s Finest – Part III”). It is our best performing recommendation and, including the special HK$7 dividend per share announced last month, has given a total return of 32.77% so far…

Hang Seng Index - Historical Price/Earnings Ration from April 2005-April 2014.

Hang Seng Index - Sector Weightings in April 2014

Happy Easter!


P.S. For more specific investment recommendations, get a 50 day risk-free trial of The Churchouse Letter.

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